When designing a hotel, the architect and development team need to create a project that is ultimately economically feasible. Unless the hotel’s owner is ego driven rather than economically motivated, most investors are looking for a return on their invested capital. Since feasibility means different things to different people, and as a hotel consultant having prepared thousands of feasibility studies, I have been asked to provide my perspective on this topic.
The process I like to use for determining whether a proposed hotel is economically feasible is to compare the total project cost (including land) with the hotel’s estimated economic value on the date it opens. A feasible project is one where the economic value is greater than the cost. Accurately estimating the total project cost is a relatively simple process for the architect and development team. However, determining the economic value is much more complicated.
The first step in the valuation process is to perform a market study where the local hotel demand is quantified and allocated among the existing and proposed supply of lodging facilities. The allocation of roomnight demand is based on the relative competitiveness of all the hotels in the market. The end result is a projection of demand captured by the proposed subject hotel, which is then converted into an estimate of annual occupancy. A similar procedure is used to project the average room rate.
The second step is to project the hotel’s operating revenue and expenses based on the previously estimated occupancy and room rate. This results in an estimate of annual net operating income. Most consultants use a five- to 10-year projection period, so this process needs to be repeated for each year.
The last step is to convert the projected NOI into an estimate of value using a weighted cost of capital discounted cash flow procedure. The end result is an estimate of economic value that can be compared to the total project cost.
Some consultants will substitute a net present value calculation or determine the internal rate of return (IRR) for the last step. However, I prefer using the economic value approach because you end up comparing “apples with apples” — i.e. cost with value.
As you can see, this process of determining economic value requires local market knowledge, hotel financial expertise and experience with valuation methodology. Luckily for architects and hotel developers, there are two simple rules of thumbs that will provide a rough approximation as to whether a project is economically feasible.
The first thumb rule tests the cost of the land to determine whether it exceeds a supportable economic land value. The following formula calculates economic land value:
Occupancy x ADR x Rooms x 365 x .04 / .08 = Economic Land Value.
As example, a proposed hotel is being considered on a parcel of land that can be acquired for $3,800,000. Zoning permits the development of 200 rooms. Based on local market conditions, the proposed hotel should achieve a stabilized occupancy of 70% and an average room rate of $150. Using these inputs the Economic Land Value would be calculated as follows:
.70 Occupancy x $150 ADR x 200 Rooms x 365 x .04 / .08 = $3,832,500.
The calculation shows the Economic Land Value is above the cost of the land so the developer is not overpaying for the land. If the land cost was $4,000,000 or above, the developer needs to re-evaluate the project because it’s not supported by the hotel’s underlying economics. Perhaps additional rooms could be added, which would increase the room count or a higher quality of hotel developed would increase the average room rate. This Economic Land Value formula works well in most markets. For prime center city locations the .04 factor can be moved up to .08.
The second rule of thumb is the Average Rate Multiplier formula. This is a very simple way to approximate a hotel’s total economic value. The formula is as follows:
ADR x Rooms x 1,000 = Economic Value
Using the numbers from the example above produces the following Economic Value:
$150 x 200 x 1,000 = $30,000,000
If the hotel’s total development cost is over $30,000,000, there could be a feasibility problem. In most cases where the development cost is significantly higher than the economic value it is because the local market’s average room rate is too low to support the contemplated improvements. In these situations the proposed plans and specifications need to be scaled back in order to produce a lower total project cost, which might then create a feasible project.
One additional point of reference looks at the percentage relationship between the hotel’s land cost and the economic value. In this example, the value of the land is approximately 13% of the overall economic value ($3,832,500/30,000,000 = 13%). This relationship should be no more than 15% to 20%. In other parts of the world where labor cost is low, this percentage relationship can be higher.
Using these hotel feasibility rules of thumb combined with a professionally prepared study will insure the architect and developer are not creating a project that has no economic viability. As with any rule of thumb, there are numerous exceptions that need to be factored into the evaluation. Before abandoning a project because the rules don’t produce the desired results, it is a good time to call in a professional consultant to prepare a more in depth analysis to either verify or dispute the conclusions produced by the rules of thumb.
Stephen Rushmore is president and founder of HVS, a global hospitality consulting organization with offices around the world. Steve has provided consultation services for more than 12,000 hotels throughout the world during his 35-year career and specializes in complex issues involving hotel feasibility, valuations and financing. He can be reached at [email protected] or 516 248-8828 ext. 204.
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the 0.08/0.04 factor is basically suggesting that the land cost should not be more than half of a stabilized year revenues. In case of more expensive locations a full year revenues. What is the rational in using 0.04/0.08?
Good morning Mr. Steve Rushmore, I would like to understand what does it mean the ".04" and ".08" in this rule of thumb ("Occupancy x ADR x Rooms x 365 x .04 / .08"). With my best regards, Tiago Carvalho.
Will it hold in countries like India where the land component comprises upto 40% of the total project cost.
The 0.08/0.04 factor is basically suggesting that the land cost should not be more than half of a stabilized year revenues. In case of more expensive locations a full year revenues. What is the rational in using 0.04/0.08? Can you explain the same.
Dear Steve Rushmore, I'd like to ask regarding the rule of thumb ("Occupancy x ADR x Rooms x 365 x .04 / .08") where the fraction of 0.4/0.8 is used, as what is the rational behind this fraction? Thanks and regards, Gavin.
Please adviase your reply to Gavin's question Dear Steve Rushmore, I'd like to ask regarding the rule of thumb ("Occupancy x ADR x Rooms x 365 x .04 / .08") where the fraction of 0.4/0.8 is used, as what is the rational behind this fraction? Thanks and regards, Gavin.
Will it hold in countries like India where the land component comprises upto 40% of the total project cost.
Good morning? I'm writing to you from Nairobi - Kenya, the most beautiful place on earth. I have recently been appointed Chairperson of the Kenya Tourist Development Corporation and given that we are firmly committed as a Country to grow and encourage investment in the hospitality by private sector enterprises at competitive prices to ensure that they rise to the challenges and leverages the opportunities presented by today's' global economy - I can't think of a better place to learn and understand what we ought to do and how than HVS. Please, get in-touch and let me know how Kenya and specifically KTDC can work with you to make Kenyan hospitality viable and attractive at this time and in the future. Regards Caroline Mutoko
How can we be the most sure about what the ADR and occupancy will be - who is the best entity to do the study that will answer this question? How reliable will the answer be if there is not a similar hotel within ten miles but many older inferior motels?
Hotel market studies are fairly accurate on the day they are prepared. However, the next day anything can change to make the study inaccurate. What if you completed a study in NYC on Sept 10, 2001. The next day was a whole new world. If you can predict what the Dow will do tomorrow with a long-term accuracy rate of more than 50%- you would be the richest person in the world. Hotel Market Studies- give you an indication of what will happen in the future. But the actual results could be much different. HVS has a lot of experience in performing market studies. Let me know if you would like to be referred to one of our offices. Thanks for reading my article. Steve Rushmore
Hello sir. I noticed you recently started responding to the talkback thread. Could you please explain the logic behind 0.04/0.08? Is it valid for every hotel in the US industry?
Sorry- the article was not clear on this point. The .04 or 4% times rooms revenue represents an assume ground rent. This can vary from around 3% to 10% of rooms revenue. The .08 or 8% is a cap rate to convert the ground rent to an estimate of land value. This rate can vary from 4% to 10%. Thank you for reading my articles. Steve Rushmore